Friday, November 11, 2016

Is Trump Bullish For Emerging Markets?

President-elect Trump may plan his first foreign visit to China, 45 years after the famous Nixon meeting with Mao Zedong in February 1972. Mr. Trump may not plan many foreign visits but a strong relationship with China will be critical to realize the new American infrastructure dream. Mr. Trump may learn a great deal from the Chinese infrastructure miracle, its modern cities, its fast-speed train network, and its leveraged financing strategies.

What are his policy priorities? How could the Chinese inspire him? And what are the implications for emerging markets? First, President Trump wants to become the American infrastructure president rather than a global policeman. His most important priority is to modernize the US transportation network with innovative technologies and smart financing. Trade wars or foreign expeditions or mass migration would be costly distractions. Infrastructure is a domestic focus but requires global capital, just like global FDI poured into China and helped finance its impressive building and infrastructure boom. China has attracted foreign capital with its growth vision, low interest rates, a stable exchange rate, and mostly passive foreign policies: a smart WTO accession (rather than trade wars), a position of military strength (rather than sending troops overseas), and addition of allies (rather than undermining of alliances). Mr. Trump may wish to relegate his campaign bluster behind his real priorities.

Second, China might inspire him in three ways: China today is the queen of leverage (see chart), just as Mr. Trump describes himself as the king of debt. China has financed its growth mostly off-balance-sheet through state banks and non-bank financial institutions, rather than direct central government spending or ineffective monetary policies. China has directed its massive spending alongside state and local administrations while developing its domestic industries: high-speed trains are made in China, new electric cars are built in China, and smart city grids are developed in China. And technological innovation was a major driver of Chinese growth while labor remained stable with low birth rates and low immigration, although urban migration has been supporting productivity.

Mr. Trump might translate these Chinese lessons to make America great again: the Rustbelt could produce innovative self-driving electric cars, the heartland could benefit from US-built bullet trains (taking bullets off the streets), and urban renewal could be enhanced by smart grids and smart new buildings. His chief economist may counsel him to refrain from picking fights abroad and instead focus on keeping positive real interest rates and a stable exchange rate as well as rebuilding leverage off-balance-sheet with new guarantees through the SBA as well as retooled Fannie & Freddie and new local vehicles. An initial boost could come from repatriated foreign earnings and tax reforms.

Third, emerging markets stand to benefit from a more inward looking US administration focused on rebuilding its domestic infrastructure. US investment would likely propel growth while inflation and interest rates would rise and the dollar would remain range-bound whereas leverage would increase significantly. The credit cycle might be further extended as financial regulations are relaxed, and risk-on trades could return quickly. A massive construction boom would benefit commodity prices as well as EM currencies, which may bode well for Russia and for Latin America. However, geopolitical tensions may increase, with a new vacuum in the Middle East and a resurgent Chinese position in East Asia. While this is not an ideal long-term foundation, it would provide additional near-term upside for emerging markets.

I read Oliver Fratzscher's comment last night and it made me think, maybe there is a bullish case to be made for emerging markets under a Trump administration.

Of course, Oliver has a vested interest in this topic as the firm he founded after being an Executive VP and Chief Economist at the Caisse focuses on emerging markets and has established a multi-manager platform with leading local managers across emerging markets.

The global bond market rout continued on Friday, driving up Italian yields and hammering emerging markets as investors feared higher U.S. interest rates under incoming President Donald Trump will spark capital outflows from these assets.

With the U.S. Treasury market closed for Veterans' Day, the bond selling centered on Europe, with Italy's benchmark 10-year yield rising to its highest in a year before a key ratings review from Standard & Poor's later in the day.This followed a wave of heavy selling across emerging Asian stocks, bonds and currencies as investors bet that Trump's fiscal policies will be inflationary, push U.S. rates up and drive investors into dollar-based assets.

This prompted the central banks of Malaysia and Indonesia to intervene in the foreign exchange market to try to stem the outflow of money, while Mexico's peso slumped to a fresh record low in its biggest weekly slide since 2008.

Developed market equities held up better, although Europe's index of 300 leading shares was down slightly and U.S. futures pointed to a slightly lower open on Wall Street.

Rising expectations that Trump's economic policies will include a heavy dose of infrastructure spending sent copper soaring more than 5 percent, on track for its biggest weekly rise since the late 1970s.

"We are turning more cautious on emerging market credit. Potential Trump policies may translate into higher U.S. rates due to inflationary pressures," Citi analysts said in a note on Friday. "Emerging market FX is now joining the Trump slump."

Europe's FTSEurofirst 300 was down 0.1 percent and Germany's DAX was up 0.5 percent, while Britain's FTSE 100 bore the brunt of a rise in sterling above $1.26 and fell 1.1 percent.

U.S. futures pointed to a fall of around 0.3 percent at the open on Wall Street as investors prepared to take some chips off the table after the Dow Jones hit a record high on Thursday. The Dow remains well on track for its best week in five years.

DOLLAR BUOYANT

Among the biggest fallers in Asia were Indonesian shares, which slumped 3 percent while the rupiah currency fell more than 2.5 percent to 4-1/2-month lows before it stabilized on the Indonesian central bank's intervention.

The Malaysian ringgit also dropped 1 percent to 9 1/2-month lows, and Mexico's peso fell nearly 3 percent to a new record low of 21.39 per dollar.

It's been a bruising week for the peso. It has fallen 10 percent - its worst week since 2008 and second worst since the 1995 "Tequila" crisis - as investors have taken fright at what a Trump presidency will mean for the Mexican economy.

Elsewhere in currencies, the dollar edged down from near 3-1/2-month highs against the yen to 106.50 yen, and the euro was a touch weaker at $1.0870.

But more broadly, the dollar is having its best week in a year, rising 1.7 percent against a basket of currencies, lifted by the rise in U.S. yields and expectations of tighter policy from the Federal Reserve next year and beyond.

The 10-year Treasury yield has this week hit its highest level in 10 months at 2.15 percent, and the 30-year yield a 10-month high of 2.96 percent .The 30-year yield rose 38 basis points this week, its biggest weekly jump since 2009. Markets are betting that Trump's policy stance - from protectionism and fiscal expansion - will boost inflation.

Inflation expectations measured by U.S. inflation-linked bonds rose to 1.87 percent, its highest since July last year, up from low below 1.2 percent touched in February.

"Sharply higher bond yields are often associated with higher implied inflation expectations, and the Fed might feel the need to respond to this with rate hikes, not delay," said Steve Barrow, head of G10 strategy at Standard Bank in London.

In a remarkable shift of sentiment, the market is also now starting to price in a chance of a rate hike by the European Central Bank for the first time since 2011.

Italian bond yields rose ahead of a key ratings review and a planned sale of Italian government bonds via auctions. The country's benchmark 10-year bond yield rose as high as 1.95 percent. Investors are also concerned that Prime Minister Matteo Renzi may resign if he loses the Dec 4 referendum on constitutional reform he pushed for.

Elsewhere, copper topped $6,000 per tonne for the first time since June last year. It is up 18 percent this week, its biggest weekly rise in over 30 years.

At this writing, emerging market shares (EEM) are down another 3% as are China's large cap shares (FXI) which are down 2%. I embedded the weekly charts of both to show you where things as of Friday morning (click on images):

A lot of investors are wondering whether or not to buy the dip on these two ETFs but before I get to that, let's look at another scary chart on long duration US bonds (TLT) which is fueling this retrenchment from emerging markets (click on image):

How violent was the shift in long bond yields after Trump's victory? Just look at the tweet below from Charlie Bilello of Pension Partners (click on image):

Now, as I stated on Thursday, I think a lot of these moves are way overdone, I told people to sell the Trump rally and think global deflation fears have not disappeared, especially if we get another crisis in emerging markets.

I also stated that if I were an asset allocator, I would use the big backup in yields to load up on long bonds here and take profits from stocks in general and wait and see how this all plays out in the weeks ahead.

Having said this, a lot of things are going to happen from now to the inauguration of President Trump on January 20th and I would be very careful here with emerging markets, commodities, gold, energy, and commodity currencies.

I have not really changed my views since I wrote my comment on selectively plunging into stocks in late August:

All I can tell you right now is what I've been telling you for a while, I see no summer crash but given my bullish US dollar views, I remain highly skeptical of a global economic recovery and would take profits or even short emerging market (EEM), Chinese (FXI), Metal & Mining (XME) and Energy (XLE) shares on any strength. And despite huge volatility, I remain long biotech shares (IBB and equally weighted XBI) as I see great deals in this sector and momentum is gaining there.

As for long bonds (TLT), if a crisis develops in emerging markets, you will see a massive flight to safety and they will rally (yields will plunge). Even if there is no crisis, a lot of pensions and insurance companies are hedging their liabilities and will be scooping bonds up on each major backup in yields.

In short, I don't see rising inflation expectations as a sustainable trend, don't think this is the beginning of a bond bear market, and I still see bonds as the ultimate diversifier in a deflationary world.

The market is anticipating a lot of things under a Trump presidency but sometimes the market gets way ahead of itself. I think investors need to simmer down and think things through as there are plenty of cyclical and structural headwinds which can clobber risk assets going forward.

Below, you will see a list of exchange-traded funds (ETFs) I track every day (click on image):

You will see the worst performers are gold miners (GDX and GDXJ), silver (SLV), energy (XLE), materials (XLB) and emerging markets (EEM). Among the top performers are small caps (IWM), semiconductors (SMH) and telecomms (IYZ).

Bonds are essentially flat but interest rate sensitive sectors are coming back after getting clobbered the last couple of days, which goes to show you there isn't much conviction that bonds will keep selling off.

As far as biotechs, the larger ones (IBB) are taking a breather but the smaller ones (XBI) continue to climb higher, even after a monster rally I anticipated and wrote about last Friday when I discussed America's Brexit or biotech moment. And many individual names I track are surging on Friday (click on images):

I started talking about emerging markets and I ended up talking about biotechs again! I apologize but love tracking the action in all sectors closely, especially in the red-hot biotech sector.

Will Trump be bullish for emerging markets and China? So far the market doesn't think so and neither do I, but Oliver Fratzscher lays out an interesting case as to why Trump's administration can be bullish for America and emerging markets.

If Oliver is right, you should be buying any major dip in emerging markets and Chinese shares, especially if rates stop rising from these levels. That all remains to be seen, I would tread cautiously in emerging markets stocks and bonds right now.

Once again, retail and institutional investors can support my work by subscribing or donating to this blog under my picture on the top right-hand side (make sure you are viewing web version on your cell phone).

I thank all the individuals who support my efforts and value my insights. Have a great weekend and to all the veterans out there, thank you for your service to your country. Happy Remembrance Day!

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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